QUICK TAKES:
- Traders who want to take advantage of high implied volatility often lean on premium collection strategies to do it.
- Wall Street strategist Tony Zhang laid out a way to do that in Uber, which reports earnings Tuesday morning.
- Uber’s implied move is more than 2X the average earnings move of the stock over the last 8 quarters.
Over the past two weeks, we’ve reviewed option trading strategies geared for arbitrating volatility through earnings. We reviewed an example in (NFLX) where underpriced options laid the groundwork for a positive-vega at-the-money straddle — which expired profitable. We then reviewed a possible opportunity in (SKX) where overpriced options offered traders an interesting opportunity to sell premium — in which our trade example expired directly within the maximum profitability zone.
We aren’t tooting our own horn here — there’s a reason there are entire hedge funds devoted to executing volatility arbitration trades like this. Strategies like these are deployed by some of the top option trading strategists on the street. And Tony Zhang, Chief Strategist at Options Play, is one of those strategists. On Friday, Tony took to CNBC’s Options Action to break down his case for why traders with a mildly bullish outlook may want to explore selling cash-secured puts on (UBER).
Tony Zhang’s Uber Earnings Trade: Sell $22.50 strike put options expiring August 19th.
The Chart in Uber Ahead of Earnings
Tony began his case for short-puts on Uber with a look at the chart.
“If we look at a chart of Uber, what we’ve seen is a primary downtrend since February of 2021. So we’ve seen a pretty long downtrend, 18 months, but what we’ve started to see here over the last couple of months is what we typically see near a market bottom, an inverted head and shoulders formation. This looks like it could target the $28 strike to the upside — so that’s a pretty material move up here that we could see on an earnings catalyst.”
A reverse head and shoulders (indicated by the three green triangles) signifies a bearish-to-bullish reversal, and is considered by many analysts to be one of the most reliable chart patterns. Additionally, Uber has remained in a relatively tight trading range over the past three months — only trading above $25 for a one-week period in June, and only trading below $20 for a matter of minutes on June 30th. This tight trading range sets up well for a potential premium collection trade. But more important to this play than the chart or the range is the implied volatility.
Uber’s Elevated IV Relative to Earnings
“What’s more interesting is the rich implied volatility going into earnings. Right now the market is implying a 12% move, versus the historical average which is less than half of that, of only 5.3% (over the last 8 quarters). So I want to do is harvest this implied volatility [...] by selling a put option. So I’m going out to August 19th and I’m selling the $22.5 puts. These are effectively at-the-money puts which elevates the extrinsic value of the option that I’m selling.”
Tony cites the most important piece of the puzzle in the above quote; the fact that implied volatility is pricing in a move that is more than twice the average earnings move over the past 8 quarters. Over the past four quarters the move is even smaller, at just 4.5%. When a stock is pricing in a massive move, and history doesn’t corroborate that move, strategists like Tony often look to sell premium against the name. That’s what Tony’s cash-secured put intends to do.
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What is a Cash-Secured Put?
“This gives me the option of potentially buying the stock if Uber is below $22.5 at the August expiration, at about $21.15 — that’s pretty much the all-time-lows. So this gives me the opportunity to participate in the earnings to the upside while collecting some premium which are quite rich right now going into earnings.”
Cash-secured puts are a common method of premium collection, popularized by Warren Buffett as a method of buying stocks at a slight discount. The trader receives a credit (the premium of the option), and in exchange makes a promise to the option buyer — if the stock price is below the strike price by the expiration date, the seller of the put option will buy 100 shares of the stock at a share-price equal to the strike price.
Issues with Tony’s Uber Trade: Downside Risk and Capital Allocation
Tony Zhang’s cash-secured put trade could allow traders to collect profit IF the implied move is far greater than the average earnings move. While we like that approach, there are a few alternatives traders could also consider.
Tony Zhang’s cash-secured put trade requires a collateral of $2,250 in exchange for a credit of $0.91 (at the most recent price). From offers a negative risk/reward skew.
While Uber being near its 52-week low could offer support, the alternative possibility is that a bad earnings catalyst sends this stock through the floor (which happened last week with (ROKU) when the stock broke below its 52-week average). If you’re in a trade that isn’t risking a large amount of capital, that isn’t a big deal. If you’re risking more than 24X the max possible reward, that could be problematic.
A Potentially Safer Solution: Short Iron Condors
Using a short iron condor strategy corrects much of these issues. If we, like Tony, believe that Uber’s 52-week low is likely to offer some support, we could opt to sell the $20/$19 put credit spread expiring August 5th, which would collect a maximum premium of $0.13 ($13). Simultaneously, if we believe (like Tony) that the chart indicates upside potential up to the $28, we could sell the $28/$29 call credit spread for $0.10 ($10). This trade requires a collateral of $77 and offers a max credit of $23 if Uber remains between $19.77 and $28.23.
With shares of Uber currently trading at $23.94, that’s a max-profit range of more than 17% to both the upside and the downside — more than 3X the average earnings move. The trade also utilizes key areas of support and resistance. In the worst case scenario of this example, the trader loses a max of $77 dollars rather than $2,250.
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Whether you’re looking to trade iron condors, cash-secured puts, or even calendar spreads, it’s important to keep an eye on volatility to find pockets of probability like this. Measuring probability against history is a great way to stack the odds in your favor when trading options.
